On 7 December 2023, Inland Revenue published TDS 23/20: Deductibility of Retention Payments. This seemingly innocuous development could easily be lost amongst the plethora of tax announcements from the new coalition Government and reminders from advisers on the many tedious rules that determine the taxation consequences of employers trying to be generous with year-end gifts and social events.

In TDS 23/20 (the Decision) the Inland Revenue’s Tax Counsel Office (TCO) decided on the deductibility of payments paid by the taxpayer to retain employees while a potential sale of the business was being considered. These sorts of payments are commonplace in M&A transactions.  While M&A activity has been somewhat subdued during 2023, it is hoped to come roaring back to life at some point during 2024, and the Decision provides an important reminder about the complexities of determining the tax treatment of payments that arise as a consequence of M&A activity.   

In this article, we summarise the Decision and provide our observations on what companies need to think about when payments to employees are being considered in an M&A context. 

Facts

The facts were as follows:

• This Decision involved a NZ-based company (Company A), which was wholly owned by Company B and a member of a consolidated group of companies (Consolidated Group). The Applicants in this case were Company A and the Consolidated Group.
• Company B entered into a transaction (Sale Transaction) to sell its interest in Company A to a third party. After the Sale Transaction was completed, Company A ceased to be a member of the Consolidated Group.
• Before the Sale Transaction, Company A entered into retention agreements with key personnel. The retention agreements entitled staff to bonus payments (Retention Payments) to incentivise key employees to remain with Company A while the option to sell the business was being considered.
• The Retention Payments were made before the completion of the Sale Transaction and conditional on the employee staying with Company A on the relevant payment dates.
• The Applicants considered that a portion of the retention payments were capital in nature and are therefore non-deductible (Capital Portion). This is because such payments were made to employees involved in the Sale Transaction.  There is no explanation in the Decision as to how the Applicants split the payments into their capital and revenue components.

Issues

The tax issues considered in the Decision were:

• Whether the portion of the Retention Payments treated as revenue in nature by the Applicants were deductible under the general permission provisions (section DA 1) of the Income Tax Act 2007 (ITA 2007);
• Whether the Retention Payments (other than the Capital Portion) were denied deductions under the capital limitation provisions (section DA 2(1));
• Whether Consolidated Group Rules under section FM 12 and section DV 7(1) applied to deny deductions for retention payments; and
• Whether the deductible portion of the Retention Payments was deductible in the income year that they are paid (section BD 4).

In this article, we focus on the first two issues considered in the decision.

Decision

General Permission

The Retention Payments were held to be deductible under section DA 1. The general permission rules provide that allowable deductions should have a connection (nexus) with the derivation of assessable income and with the carrying on of a business. This is a fact-sensitive enquiry, but the Decision makes it clear that Taxpayers must consider whether “the occasion of the loss or outgoing should be found in whatever is productive of the assessable income”. On the facts, the TCO was of the view that the general permission was satisfied as the Retention Payments had been incurred on payment to key employees as part of carrying on its business. 

Capital Limitation

The Decision held that the capital limitation did not apply to deny the deduction. It arrived at this conclusion through a classic “capital vs revenue” analysis, considering longstanding  Australian case law (such BP Australia Ltd v Commissioner of Taxation for the Commonwealth of Australia [1966] AC 224 (PC)) and New Zealand’s own CIR v McKenzies (NZ) Ltd [1988] 2 NZLR 736 (CA).  It certainly felt like a trip down law school memory lane!  As outlined in the Decision (and referencing both BP Australia and McKenzies) the five indicia to be considered in a capital vs revenue analysis are:

• the need or occasion which called for the expenditure;
• whether the payments made were from fixed capital or circulating capital;
• whether the payments were of a once and for all nature producing assets or advantage or an enduring benefit;
• how would the payments be treated under ordinary principles of commercial accounting; and
• whether the payments were expended on the taxpayer’s business structure or whether they were they part of the process by which the income was earned.

The nature of retention payments in an M&A context calls for a close investigation of the circumstances surrounding such payments. For example, in this case, the Retention Payments could be characterised as an incentive to retain key staff for business operations to carry on OR as payments incurred in the course of the disposition of capital assets. Although the facts in this case were said to be “very finely balanced”, the TCO held that the Retention Payment kept its revenue nature as the way the amounts were calculated was to retain staff while the transaction was being considered (i.e. they were paid to ensure that the business continued to operate as usual).

Observations

While TDS 23/20 is a technical decision and not binding on the Commissioner, it is nevertheless very interesting and highly relevant to the consideration of expenditure incurred in M&A transactions, particularly when it comes to payments made to employees.  Generally, payments to employees are treated as deductible, either under the general permission or specific provisions of the ITA 2007.  But where made in the context of, or in connection to, a business sale this will not always be the case.  

This can be the case with respect to retention payments and special bonuses, but also with respect to employee shares schemes where arrangements can be made to accelerate the vesting of options and shares or to compensate employees for the cancellation of a share scheme arrangement as a consequence of a business sale.  The recent Australian decision in Clough v Commissioner of Taxation [2021] FCAFC 197 highlights that employee share scheme payments can also be treated on capital account.  While the statutory provisions in the ITA 2007 that provide for employer deductions for employee share scheme expenditure differ from Australia, this case highlights that if payments to employees are made only in connection with a business sale and are not contemplated by the share scheme, they may well be treated as being on capital account and therefore non-deductible. This remains an area we hope the Commissioner will provide some guidance on.

In summary, there are two critical points to note with respect to payments to employees in an M&A context:

1. The facts and circumstances must be very carefully considered and the reason for employee payments being made will be critical in determining whether or not they are revenue in nature.  It cannot automatically be assumed that employee payments will be deductible.
   
   
2. The leading cases on capital vs revenue remain timeless.  Their principles developed, refined and interpreted over many decades remain as relevant today as they did back in the forties, fifties and sixties.   

As M&A activity hopefully picks up during 2024 the Decision is a timely reminder of the importance of undertaking this sort of fundamental analysis.  

This article was produced with assistance from John Alcantara, a Solicitor in the Corporate and Commercial team.